Diving Into Pool Corp.

The U.S. has a negative savings rate, and the Federal Reserve has raised rates 17 times since 2004. Given those conditions, I'm cautious about owning stock in any company that sells discretionary products or services to homeowners, unless it has high-quality earnings growth or sells at a low multiple.

Take, for example, Pool Corporation (POOL - commentary - Cramer's Take), which distributes pool equipment, chemicals and related backyard leisure products. This stock has soared over the past decade, and fellow RealMoney contributor David Peltier recently wrote a column in which he said that Pool looks attractive at $38, in part because of insider buying.

This stock has plenty of other fans, too. The company's earnings results have been improving: Diluted earnings per share for the six months ended June 30 were $1.23, vs. $0.99 for the year-ago period. In 2005, Pool earned $81 million (after stock-based compensation) on revenue of $1.6 billion, vs. $5 million of profit in 1996 on $236 million of revenue.

Potential Downside

Given this impressive track record, Pool should continue to prosper. But for me to buy a company selling at 22 times trailing earnings, I want museum-quality growth, and Pool comes up short. While GAAP profits are rising, free cash flow, or what I call defensive profits, have declined every year since 2003, as the Quality of Profits Chart below shows. This negative divergence has continued into this year, as defensive profits for the 12 months ended June 30 were negative $28 million, versus $5 million for the 12 months ended June 30, 2005.

Quality of Profits Chart This negative divergence has continued into this year.

Why are GAAP and defensive profits heading in opposite directions? It's because of capital spending, acquisitions and investment in working capital, which the defensive income statement expenses dollar for dollar in the period incurred because they are uses of cash. In contrast, these outlays are indirect expenses in the GAAP and Economic Value Added, or enterprising, P&Ls. (To learn more, visit my Web site.)

---

At the time of publication, Heiserman had no positions in any of the stocks mentioned in this column, although holdings can change at any time.

Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit www.earningspower.com. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.